How Are Home Equity and Refinancing Related?
Whether you’re a first-time homeowner or on your third house, there’s a certain amount of satisfaction in seeing the principal balance on your mortgage tick down with each monthly payment. The difference in that margin between what your home is worth and how much you owe on your mortgage is called your home’s equity. If you originally took out a $180k mortgage and have paid off $40k, that means you’ve accrued $40k of equity on your investment.
Sure, the end game might be to pay off the home and own it free and clear. But then comes an expense: a natural disaster, family tragedy, or unexpected medical necessity. Luckily for you, there’s a way to recapture that equity in cash by refinancing your home. In fact, you may even be able to capitalize on more than your known equity, depending on the current appraised value of your house.
Loan-to-Value Ratio
There are many steps to a refinancing, or “second mortgage”, process. One important early step is to determine your loan-to-value ratio. If you think your home has gained in value since your purchase, maybe thanks to improvements like a new roof, kitchen remodel, or even landscaping, the first thing you’ll need is a fresh appraisal, which you’ll obtain with the help of your lender.
If you took out that $180k mortgage, but now your home is worth $200k, that’s additional equity. From there, the math is simple: divide your current loan balance by your home’s current assessed value. For example:
140,000 / 200,000 = .70
That means your loan-to-value ratio is 70%. You’d likely be able to refinance for a very competitive interest rate at that ratio. But what were we saying earlier about being able to recap some of your equity? That means a bit of a change to the math. If you want to borrow an additional $25,000 against your home’s value, you’ll add that to the balance of your loan to illustrate to your lender the risk involved. So in that case we’d see:
165,000 / 200,000 = .825
With the additional $25,000 of the home equity loan added to the balance, your loan-to-value ratio rises to about 82%. Most lenders will require a LTV ratio of 85% or lower to consider refinancing, so you’d still be in a decent position.
Ultimately, relieving yourself of the burden of the mortgage will feel better than taking the short-term option for frivolities. Just because you can refinance doesn’t always mean you should! But if you need money fast, want a lower interest rate, or want to consolidate smaller debts into a lower-interest, longer-term loan, a refinance might be the option for you.
Written by: Jeremy Cooley, Team Leader at Royal United Mortgage LLC
Published: 11/5/2015